FX Markets – The Foreign Exchange Boom

- 17 February 2011

This week we’ll take a look at one of the fastest growing financial market on the planet – the Foreign Exchange market. Foreign exchange, also known as “Forex” or “FX” is the exchanging of one country’s currency for another.

Take for example exchanging one Australian Dollar (AUD) for one United States Dollar (USD). We’re all familiar with such a transaction as we probably see this exchange rate every night on the news. Currently, the Australian Dollar and the US dollar are worth approximately the same amount, that is, one AUD equals one USD. In this case we say that the exchange rate is 1.0000 or that the AUD is at “parity” with the USD.

In the past, we’ve probably been more accustomed to seeing the AUDUSD exchange rate around 0.7500. This means that one AUD at the time was only worth $0.75 USD. If we were to go on a holiday to Disney Land and we exchanged AUD$100, we would have received only USD$75. Today however, your AUD$100 is going to buy you a whole lot more Mickey Mouse souvenirs because it is fetching a whopping USD$100!

FX markets are not only the fastest growing biggest in the world, but also the biggest, with over US$4 trillion worth of currencies being exchanged each day. To put this into comparison, this is approximately 4,000 times more than the entire comparative daily turnover of the Australian Securities exchange.

Not only are FX markets big, but they are always on the move. FX markets trade 24 hours a day, five days a week, with New Zealand typically kicking off proceedings on a Monday morning and the New York concluding them on Saturday morning our time. In theory however, if you were really keen, an FX transaction could still be done on a Sunday out of Dubai in the Middle East!

These characteristics of being immensely large, and offering almost unending trading abilities, result in FX affording investors and traders alike some of the best opportunities to grow their wealth when compared to any other instrument.

Liquidity beyond imagination

When we say that the FX market is “deep and liquid” we mean that at any one time, there are literally trillions of dollars of buyers and sellers of the major currency pairs looking to transact with each other.

When Qantas purchases a new Airbus 380, they will need to pay for it in Euros (Airbus is based in France). This will mean taking roughly $300 million Australian Dollars (AUD) out of their bank account in Australia, and converting it to Euros (EUR), and send to deposit in Airbus’s bank account in Paris. We could give many more examples of international trade, for example BHP selling 1,000 tonnes of iron ore to the Chinese, but if you can imagine the scale of all of this trade, you can easily understand why the FX market is so liquid.

In our stock market reports, we’ll often have trouble finding liquid stocks in Australia to trade. Even a Top 5 stock like Rio Tinto (RIO) at times can have very few shares available to buy or sell. At the time of writing, there is less than $2.5 million worth of RIO stock available within 1% of the current share price.

Imagine you are an overseas hedge fund looking to buy $10 million worth of RIO (a relatively small amount when you think that RIO’s capitalisation is over $100 billion dollars!). You would have a tough time purchasing this stock without pushing the price up. With FX, there are no such impediments, and even institutional players have little trouble trading in and out of these markets without moving the price at all.

FX is traded in very small price increment points or “pips” for short. The effect of all of the liquidity sloshing around in FX markets means that buyers and sellers are forced to crowd together and offer each other the most competitive prices in order to expedite their transactions. As a result the spread between the best bidder in the market and the best seller in the market is typically very small. The AUDUSD can be traded from as little as one pip which is 0.0001 of one dollar (one-ten thousandth of one dollar). Further, as FX brokers very rarely charge commissions (as one would expect with so many customers the industry is extremely competitive), a currency pair like the AUDUSD can therefore be traded with very little cost indeed.

Compare trading with a cost of one-ten thousandth of a dollar to buying 500 shares of Telstra! Currently the Telstra share price is $2.94. 500 shares would therefore cost us $1,470. The spread on Telstra is one cent. This is an unavoidable cost of dealing which all investors and traders must factor into their profit and loss accounting. If we were to sell Telstra immediately after we purchased it we would lost the value of the spread per share, or one cent times 500 shares. If you do the maths this equates to $5. On top of this $5 spread cost we will undoubtedly also have to pay brokerage, and don’t forget good old GST! Let’s say that you did this transaction through a discount broker and paid $19.95. Your total transaction costs on this Telstra purchase were therefore $24.95 which represents 1.69 cents for each dollar you invested. This is a whopping 169 times more expensive than the FX trade.

We’ll go into more detail on the FX markets in next week’s MarketPulse article. Hopefully however, you can already see some of the incredible benefits in trading FX over old fashioned shares which unfortunately most investors limit themselves to. Certainly if one considers that a dollar saved is a dollar earned, then paying 169 times less commission is going to add up to major advantage over a long period of time.

Australian Stock Report has just launched a series of FX workshops called “Fast Track FX”. These workshops are designed to show investors of all experience levels and backgrounds how to most effectively trade the exciting foreign exchange markets. The workshops will be run by one of the best FX traders in Australia, Kel Butcher, and are certainly going to be a not too miss opportunity to expand one’s trading horizons. For more information on the Fast Track FX workshop and how you can secure your seat, click here.

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